Will humble pie be served in 2000?

As I write this column in early September, most of the nation's real estate markets are still charging ahead in the development boom phase of the real estate cycle, a phase that began around mid-1997. True, this development boom was interrupted for a while in the fall of 1998 when a brief worldwide financial panic triggered by Russian debt defaults froze extensions of credit of all types. But the resulting slowdown in new development projects was not long lived. In fact, new development projects of all types are blossoming almost all over the nation. So the current question is: Will this development boom result in another round of overbuilding similar to that in the late-1980s, or will this time be different?

As readers of this column know, I define the commercial property cycle as having three basic phases. The development boom phase starts when the general economy is at the peak of its expansion, as it is now. Overall space demands have cut vacancies low and raised rents, so developers start building new space. We had the greatest development boom ever in the late-1980s, which led to huge overbuilding.

But just when all that new space comes onto the market, as in the early-1990s, the overall economy goes into a recession and space demand stops rising. That caused the overbuilt phase, which lasted unusually long in the early 1990s - until 1993. New building stops, rents fall, values fall and vacancy rates soar. Office values collapsed by 40% to 50% in that period. Other values declined too.

Then, the overall economy goes into a new expansion and space demands start rising again. This gradually reduces vacancies, but rents remain low and little new building starts. This is the gradual absorption phase, which lasted from 1994 into 1997. Eventually, if the general economic expansion continues long enough, this phase creates the conditions for a new development boom.

Such a boom began in late-1997, and was fully underway in the first three quarters of 1998. After the pause mentioned above, financing has returned to real estate markets, especially debt financing in the forms of traditional mortgages and commercial mortgage backed security (CMBS) credit.

Although real estate investment trusts (REITs) cannot raise equity capital nearly as easily as they did in 1996 and 1997, developers are finding equity capital somewhere. Consequently, the full-scale national development boom has resumed across the nation in most markets. In most areas, space markets are still strong, but the peak of demand growth has probably passed.

The key question now is: Will developers overbuild markets again as they typically have done in past cycles especially in the late-1980s? The lending pause in late-1998 slowed the financing of many new real estate developments, and this slowdown lasted well into 1999. Advocates of REITs and CMBS claimed this showed the superior wisdom of public market investors as opposed to traditional lenders. They argued that public markets will shut down capital flows when there are any signs of overbuilding, thereby preventing significant overbuilding.

But loan funds are now readily available, even from CMBS conduits, though they require more equity than in the past. And much of the new development is being debt financed from traditional sources, such as insurance companies and banks, and not by Wall Street and undertaken by traditional developers - not public REITs. So, significant overbuilding is still quite possible. In fact, local overbuilding of all types will become more and more widespread as 2000 goes on. That will occur, although the general economy will continue to expand. Therefore, demands for space will keep rising.

Thanks to the entrepreneurial energy of U.S. developers, construction of new space can rise even faster, producing a tendency towards space surpluses. This is already happening. In the 1980s, the amount of new commercial building placed under contract exceeded 1 billion sq. ft. in only three years - 1985, 1986 and 1987. In the 1990s, this amount fell to 556 million sq. ft. in 1992. But it has exceeded 1 billion sq. ft. in 1997 and 1998, and will do so again in 1999. The 1998 total was larger than during any one year in the 1980s. That means a lot more new space will appear in 2000 and 2001.

In the second quarter of 1999, suburban office vacancy rates rose in more than 75% of the major markets measured by Los Angeles-based CB Richard Ellis, though downtown vacancy rates fell in more than half of the downtown areas measured. Although nationwide industrial vacancy rate remained at 5.8% in the first quarter, the amount of new industrial construction more than doubled from 1997 to 1998, and is staying at the 1998 level in 1999. This indicates that additions to the space supply are out-pacing additions to demand in many areas, despite continued growth in the economy.

There are still some markets where undertaking new development projects is feasible, since vacancy rates are still falling there. But in most markets, extreme caution should be used before building, even if user demands for space are rising. This is particularly true of new speculative space built without solid preleasing.

True, more information about what has been and might be built is available than in the 1980s, in part because of Wall Street's many stock analysts studying REITs. But it was not lack of information that caused overbuilding in the 1980s. Two other factors were more important. One was the egotistical attitude among developers, each believing he should build his project, even if the total market would be overbuilt, because he would surely out-do the competition. That egotism is an essential ingredient in any successful developer's personality, but, in the end, it can lead to overbuilding. The second factor was the strong incentive among financial institutions to put out money in order to make fees. That incentive still exists today.

I have not noticed a great welling up of humility among developers I know. Their propensity to overbuild is still there. And sources of capital are still pressured to make deals to get the money out, even when the money is coming from Wall Street. This was proven by the frantic bidding for properties by REITs when they had an abundance of cash in 1996 and 1997. They drove property prices to high levels in an effort to grow rapidly. Thus, Wall Street, too, can overreact to market incentives to put money out.

In summary, we are still in a development boom in most markets, and the boom has been speeding up again after a major pause. But most markets are becoming more vulnerable to overbuilding. True, I do not expect an overall recession in 2000; so we will not be plunged into a drastically overbuilt situation as we were in 1990. The overbuilding that may take place will be much milder than it was then. But the time to anticipate overbuilding is before projects are created - not after they are done. So, think carefully before you lavishly sink capital into new speculative developments.